Written by: Sudhir Roc-Sennett, Senior Portfolio Advisor, Vontobel Quality Growth Investment Team
The outlook for higher interest rates this year in the U.S. has supported a stronger U.S. dollar. At the same time, across the emerging markets there has been a broad range of FX performance with some sharp sell-offs. Over the second quarter to date, currency impact has lowered the +0.71% local currency return of the MSCI Emerging Markets Index to -2.10% in USD. We believe this volatility reflects a change in investment opportunity as rates rise - early steps of the market turning the corner from a low rate/risk-on environment towards a more sanguine view of risk pricing, as the bond market draws investors back from equities. We do not believe there has been an abrupt change in fundamental risk across the major emerging markets.
The last time we saw a major sell-off in EM currencies was the taper tantrum of 2013, when the markets first flinched on the prospect of higher rates. The "Fragile Five" (Turkey, Brazil, India, South Africa, and Indonesia) emerging market currencies sold-off as investors focused on these countries’ double deficits, both current account (net international business flows) and fiscal (government budget). Despite the volatility and sell down, there were no fundamental blow ups in 2013. While this illustrated a level of economic robustness that had not been tested for a few years, it also acted as a wake-up call. Central banks and governments across the emerging markets took note, and since then deficits from a number of countries have narrowed.
When assessing risk today, we see areas of relative weakness that stand out, including:
- Weak budget management. Low cost debt provides room for fiscal attitudes that might not sit well in tighter market conditions – e.g., Turkey or South Africa under Zuma (things may start to look better under Ramaphosa).
- Debt has risen sharply across a number of lower income countries, in part due to China financed infrastructure.
- Exposure to foreign denominated public debt.
- Likely rising current account deficits for energy importers such as India.
Recent currency weakness has focused on countries with double deficits, and in particular those running larger budget deficits. These include markets such as Argentina, which has turned to the IMF for support, Turkey, and Brazil. In contrast, the currencies of ASEAN countries that are generally running current account surpluses and the Chinese Renminbi have remained relatively stable against the US dollar.